The Economics of Integration

Ioana Negru
Lecture nr. 3 (part 1)
What is integration?

■ Economic and political integration between

the member states of the European Union
means that these countries have to take joint
decisions on many matters
■ They have developed common policies in a
very wide range of fields - from agriculture to
culture, from consumer affairs to competition,
from the environment and energy to transport
and trade
The stages of Integration (Balassa
1961)
■ A. Free Trade area: the member states
remove all barriers on trade between
themselves but retain the freedom to
implement different commercial policies
towards third countries
■ B. A customs union: the member states
remove all barriers on trade between
themselves and introduce a common
external commercial policy towards the rest
of the world
The stages of integration (Balassa
1961)
■ C. common markets: customs unions that
allow free factor mobility; freedom of
movement of goods, services, labour and
capital
■ D. Economic and monetary union: include a
common market and coordination of fiscal and
monetary policies, a common money or
complete convertibility among national
currencies with no possibility of exchange-rate
adjustments and a common authority to act as
a central bank
The stages of Integration (Balassa
1961)
■ E) Political Union: involves a central authority
that has supranational powers similar to those
of a nation’s government over various policy
areas such as foreign policy and is responsible
to a directly elected central parliament
EU enlargement and integration
 Why should preferential arrangements be
preferred to unilateral trade liberalisation?
■ Traditionally, ‘customs union theory’ attempted to address
this question and assess the effects of customs unions
using instruments from welfare economics.
■ More recent analysis takes into account the dynamic
effects of integration such as exploitation of economies of
scale, increased competition and more rapid technology
transfer. Empirical studies suggest that these dynamic
effects of integration may be more important than the
static welfare effects.
The ‘static effects’ of integration
Viner (1950) made the distinction between trade creation
and trade diversion:
■ Trade creation arises when domestic production is
replaced by cheaper imports from a partner country.
■ Trade diversion involves low-cost imports from
suppliers in third countries being replaced by more
expensive imports from a partner country.

It was generally assumed that integration would lead to

a welfare gain because the positive effect of trade
creation would exceed the possible negative effects of
trade diversion.
Trade creation
■ The ‘static’ effect of a customs union can be illustrated
for a simple case.
■ Assume that Belgium imports product X and that
Belgium is a ‘small nation’.
■ Initially Belgium imposes a non-discriminatory ad
valorem tariff of 100 per cent on imports from all
sources.
■ If Belgium now forms a customs union with Country 1
(Germany), the tariffs will be removed on German
imports, but not on those from country 2 (the rest of the
world).
Trade creation
Trade diversion

■ Assume that with free trade the price of product x is €1

in the USA and €1.50 in France.
■ With a 100 per cent non-discriminatory tariff the home
country (Belgium) will import from Country 2 (the US)
at a price of €2. There will be no imports from France
as the price inclusive of tariff is €3.
■ If Belgium forms a customs union with Country 3
(France) but not with Country 2 (the US) tariffs are
removed on imports from France, but not on imports
from the US. After formation of the customs union
Belgium will import from France at price €1.50.
Trade Diversion
Non-discriminatory tariffs and preferential
arrangements
■ The analysis based on import demand and supply
curves can be used to illustrate the difference between
non-discriminatory tariffs and preferential
arrangements.
■ Non-discriminatory tariffs: e.g. those extended to all
WTO members on the basis of the most-favoured-
nation clause (MFN).
■ A customs union: all members eliminate barriers on
trade with their partners and introducing a common
external tariff towards the rest of the world.
Viner’s ambiguity
■ The net effect of forming a customs union on the
welfare of the home country may be positive,
negative or zero.
■ This is known as Viner’s ambiguity.
■ Ex ante general predictions of the welfare effects
of introducing customs unions cannot be given as
they will depend on the case in question.
■ The analysis of the introduction of a customs union
is a case of second best in which a shift from one
sub-optimal situation to another does not permit
generalisations about the overall effect on welfare.
The
The conditions
conditions under
under which
which the
the benefits
benefits ofof introducing
introducing aa
customs
customs union
union (cu)
(cu) on
on welfare
welfare are
are likely
likely to
to be
be higher:
higher:

• The higher the tariff before forming the cu;

• The lower the common external tariff;
• The higher the number of countries joining the cu, and
the greater their size;
• The smaller the differences in costs of production
between the members of the cu and third countries;
The closer the countries are geographically;
• The more competitive rather than complementary the
economies of the member states are;
• The greater the trade flows and economic relations
between the countries before forming the cu.
Preferential trade liberalisation versus non-
discriminatory measures: The early literature
■ The traditional static analysis assesses the
overall impact of a customs union by
comparing the situation before and after
creation of the customs union.
■ Cooper and Massell (1965) challenged this
approach, arguing that the comparison should
be made between discriminatory reduction of
tariffs, as in the case of a customs union, and a
non-discriminatory elimination of tariffs.
Cooper and Massell

■ Cooper and Massell argue that a non-

discriminatory removal of tariffs would not
involve trade diversion and would be superior.
■ The question then becomes why countries
create customs unions (or preferential trade
liberalisation) rather than use non-
discriminatory trade arrangements?
The terms of trade argument
■ There may be a possible terms-of-trade loss from
unilateral trade liberalisation, and a possible terms-of-
trade gain may arise for the customs union as a whole
as result of discrimination against the rest of the world.
■ The individual member states may be too small to
affect their external terms of trade individually, but
together they are able to affect the terms of trade with
third countries.
■ However, the customs union could risk retaliatory
measures from other countries.
Political Economy argument
Johnson (1965) introduces political economy
arguments to maintain that countries with a
strong preference for industrial production that
are (or feel themselves to be) at a comparative
disadvantage vis-à-vis the rest of the world
may favour the creation of a customs union.
Early empirical research on the effects of
integration
■ Early empirical research based on the customs
union approach found the effects of integration
surprisingly small.
■ This seemed a remarkably small reward for all
the effort of creating the Community, so led to
questioning of the approach, and the
emergence of the view that integration might
also involve dynamic effects.
The dynamic effects of integration are said to
include:
■ specialisation,
■ increased competition,
■ economies of scale,
■ technological progress,
■ increased bargaining power at an international
level, and
■ more rapid growth.
Growth and Integration
According to orthodox neo-classical growth theory (based
on the pioneering work of Solow, 1956), the key
determinant of growth is capital accumulation.
• The basic assumption of the Solow model is that people
save and invest a certain percentage of their income
each year, so the inflow of investment is a fixed fraction
of output per worker.
• If y is output per worker, the curve sy shows investment
per worker (which is equal to savings per worker). The
shape of the sy curve reflects diminishing returns.
The Solow Growth Model
The Solow Growth Model
• The ratio of capital to labour in an economy will
depend on investment, but also on depreciation,
as old capital has to be replaced and repaired.
• A constant fraction n of the stock of capital is
assumed to depreciate each year.
• Accumulation of capital cannot be an ongoing
source of long-run growth. In order to explain
ongoing rates of growth other elements (such
as technology, or the role of human capital)
have to be introduced.
Growth and Integration
■ Integration may facilitate international flows of
knowledge. This could reduce the cost of innovation,
increasing the private return on R&D and encouraging
more resources to be drawn into innovation.
■ Integration could also have a positive effect on financial
markets, leading to higher levels of investment and
long-term growth.
■ Empirical estimates run into difficulties as it is difficult
to isolate integration from other variables influencing
growth.(Deardoff and Stern, 2002); Baldwin (1989)
substantial growth effects from the Single Market
Programme
Does regional co-operation act as a stumbling block or
building block to multilateral trade liberalisation?

■ The domino effect described by Baldwin

(1993): outsiders want to become insiders
increasing the incentives to add members to
the integration bloc. This enlarges the market
causing other countries to be pulled in as well.
■ Against this there may be competing trade
blocs, or a ‘spaghetti bowl’ phenomenon
caused by the overlapping of complex systems
of trade concessions.
Regionalism versus multinationalism

The new regionalism approach may also help to

identify the characteristics that are likely to lead
to success (or failure) of a regional bloc. A
study by the World Bank (2000) argues that a
strong liberalising arrangement with the right
partner (preferably rich, large and open) may
lead to a virtuous circle of increased credibility,
investment, growth and political stability.